In today’s tight labor market, your company may be forced to turn to temporary help to accomplish certain projects. If you hire an independent contractor, you’ll want to make sure you treat that person as just that and not as an employee, as determined by the IRS.
The stakes for the hiring company are high. Because a company is relieved of all federal tax responsibility (FICA, unemployment, and income taxes) for independent contractors, it can be attractive to treat any temporary worker as an independent. But if the IRS determines that you misclassified a temporary employee as an independent, you’ll have to pay that obligation. You may even owe a penalty.
This article provides an explanation of the IRS guidelines for whether a worker is a temporary employee or an independent. Essentially, the IRS looks for one main thing: the right to direct and control. To further refine this central issue, the IRS and the Social Security Administration have developed a list of twenty criteria, generally called the Twenty Factor Test, which has been used in settling court cases in which worker status was challenged. Those criteria will be discussed as well.
Contractors: You’re not off the hook either
Even though the hiring company bears the financial risk of reclassification, if you’re an independent contractor, make sure you also follow these guidelines as closely as possible. Although you don’t face the financial penalties for noncompliance, it’ll be easier to expand your client list if you can demonstrate that you know the rules and can help keep your clients out of trouble. Writing many of these provisions into your contracts serves not only as protection for your clients, but also as protection of your rights as an independent contractor. (See my article on writing contracts for additional information.)
The right to direct and control
In determining a worker’s status, the IRS looks for whether an employee-employer relationship exists. Quite simply, the IRS finds that this relationship does exist when the hiring company has the right to control how the work is to be done, regardless of whether the company exercises this control. The hiring company can specify the end result of the independent contractor’s work but not the means by which the contractor will accomplish that final goal.
The Twenty Factor Test
You can use the IRS’s Twenty Factor Test as a guideline in your dealings with an independent. Violation of any one of the factors could result in a reclassification of the worker. However, if a case is sufficiently strong on most other factors, violating one factor doesn’t necessarily change your independent into an employee.
If you’re particularly concerned about this issue, you can find detailed information on these criteria plus case studies: The IRS’s auditor-training materials for determining whether a worker is an independent or an employee are available to the public. The page http://www.irs.ustreas.gov/bus_info/training.html contains a link for downloading the PDF file.
Right of control
The following rules pertain most directly to determining whether the hiring company has the right to control the employee, or whether the contractor can determine how and where to accomplish the project. These rules are as follows:
- Don’t provide instructions: Contractors are not required to follow detailed instructions on how to do their work. The company provides only its requirements for the finished product.
- Don’t set a sequence: Contractors decide in what order they work on various parts of a project in order to deliver the final product.
- Don’t set the contractor’s work schedule: Contractors set their own work hours.
- Don’t specify the location of the work: Contractors decide where they work. If the nature of the project requires that some work be done onsite, the company doesn’t control or supervise the contractor’s activities while in the office.
- Don’t restrict the contractor’s work: Contractors are not restricted from working for other clients even while they’re working for you.
- Don’t require a contractor to work full-time: Similarly, contractors determine the time necessary to complete a project. Contractors do not have to work full-time for one client, which would restrict them from finding and doing other work.
- Don’t require reports: Contractors don’t have to submit regular reports, either verbal or written, on a project.
Compensation and expenses
The next set of factors pertains to how the company compensates contractors and how contractors run their businesses. You don’t have as much control over some of these factors, so be sure to look for contractors who know what they’re doing:
- Contractors have the potential to incur either profit or loss: Contractors can make a profit or suffer a loss from their work. Contractors are not usually compensated by period of time: Contractors are generally paid by project, receiving a lump sum payment or periodic payments on a fixed schedule. The IRS considers payment by period of timeŸhour, week, or monthŸto indicate an employer-employee relationship, because it subverts the previous guideline by guaranteeing the worker a return for his or her labor. (Note that this factor may not have to apply if it is customary for a contractor in that particular trade to be paid by a unit of time.)
- Contractors pay expenses for business and travel: Contractors pay their own expenses, including those for business and travel. Otherwise, the hiring company would be directing the contractor’s business activities.
- Contractors pay expenses for supplies: Contractors also pay for their own tools, materials, and all other equipment. If the company supplies such materials, the contractor should lease them at the market rate.
- Contractors make an investment in their own equipment and facilities: Contractors are able to perform work without using the company’s facilities, such as by renting office space or maintaining a home office. Contractors invest money in their own office and business.
- Limited right to fire contractors: Interestingly enough, contractors have greater “job security” than employeesŸcontractors cannot be fired so long as they meet their contractual obligations, while employees can be fired for no reason at all.
- Limited right for contractors to terminate: The flip side of the previous rule is that while an employee can leave a job at any time for any reason, the contractor must fulfill his or her contractual obligations to the company, or face possible legal action.
Role of the contractor in the company
Finally, the last group of factors seeks to determine whether the worker is treated like other employees and provides services critical to the company:
- Contractors aren’t trained: Companies don’t provide free training for contractors. An important reason for using a contractor should be his or her unique, specialized skill that no one in the company already possesses.
- Contractors aren’t integrated: Contractors should not play a critical role in the company’s operations.
- Contractors have the right to assign: Contractors don’t have to personally perform services but instead have the right to hire others to do work.
- Contractors hire their own assistants: Similarly, contractors control their own assistants. The hiring company does not hire, control, or pay assistants for contractors.
- There is no continuing relationship: Contractors don’t work steadily for any one client. Although they may perform several projects for one client, contractors work irregularly and only when work is available.
Get it in writing
If your independent contractor doesn’t supply a contract that includes most or all of these provisions, have them added. Remember, it doesn’t matter if you actually direct the contractor but rather whether you have the right to do so. Spelling out these guidelines in your contract helps prove what your rights are and aren’t. Of course, there are the additional, obvious factors you should be sure to follow: Contractors pay their own taxes and don’t receive benefits.
Don’t let this keep you from working with the best
One last word: Unfortunately, the possibility of IRS meddling scares some companies away from working with independent contractors. Instead, they go through temporary agencies because the agency employs the contractor and covers the tax liability.
This is really too bad, not just for independents like myself but also for the hiring companies. A competent independent contractor is often the best person for the jobŸthey’re self-directed and responsible, and because they do their own marketing and live by their references, it’s in their best interest to complete your project ahead of time and above your expectations. On the other hand, a temporary contract employee has far less at stake on the project than do your employees and has no incentive to work quickly.
Instead of discriminating against the self-employed, make sure that your independent contractors know what they’re doing: How long have they been in business for themselves? What do their past clients have to say? Do they present well-written contracts that protect you as the client, or are they willing to sign such a contract?
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Meredith Little has worn many hats as a self-employed writer, including technical writer, documentation specialist, trainer, business analyst, photographer, and travel writer.